During September, three members of the BAM investment team, Ned Bell, Patrik Sjöblom and Joel Connell embarked on an extensive research trip through Europe. As bottom-up fundamental investors, our objective was to find new ideas, test existing company theses and identify broader trends which may impact the portfolio as a whole.
Our starting point, as always, is our universe of investible companies, which means they must have delivered three consecutive years of an ROE in excess of 15% and have a market capitalisation in excess of $1 billion. During the trip, we met with 68 of the 308 European companies that screen for us according to these criteria. We also met with another 30 companies that we expect will come into our investible universe or could give us some unique insight into our investible companies (i.e. competitors, suppliers, distributors etc).
While we met with companies from a wide range of sectors, we had more of a focus on those in the Health Care, Industrials, Consumer and IT sectors.
We also had a particular focus on meeting with companies that we would classify as Small and Mid Cap, as we are currently finding more compelling valuation opportunities in this space post the Brexit vote.
Company Insights – what has changed
Throughout the course of meeting with a wide range of companies over a few weeks, there are always a number of key takeaways from company management that get our attention. As long term investors we are always particularly interested in broader economic, structural and industry trends, with respect to the impact they can have on stocks we own or are considering for client portfolios. Below are some of the key takeaways that we believe are worth highlighting:
Electric Vehicles – about to get very interesting for Tesla and the OEM’s
In the past we have been nothing more than interested observers in this space, as the likes of Tesla are simply unprofitable and don’t pass the first step of our investment process.
In our meeting with Daimler in Munich, they conveyed that they have now decided to launch a full range of electric vehicles by 2019. Why now? Because they now believe that the EV space will be a very profitable one going forward. What does this mean for the likes of Tesla? Daimler described Tesla as “the only ones on the dance floor” – the inference being that they are happily manufacturing vehicles in an industry that currently lacks scale and therefore profitability.
We also heard very similar sentiments from the likes of BMW, Continental and Infineon who all confirmed that the big German OEM’s were now committed to a fully-fledged roll-out of Electric Vehicles.
As we look ahead, we believe that the major OEM’s like Daimler and BMW have several major advantages over Tesla which will make it extremely difficult for them to compete:
- Daimler and BMW are simply much better manufacturers than Tesla.
- Daimler and BMW’s captive financing businesses give them a considerable advantage over Tesla, in that they are able to effectively control the pricing of second hand vehicles and therefore have better pricing power over new vehicles.
- Tesla on the other hand, have no control over the pricing of their second hand vehicles when they come on the market.
- Tesla’s weak financial condition will make it extremely difficult for them to remain competitive with the big OEM’s as they ramp-up their EV presence.
Key Takeaways: the EV market is about to get far more competitive and life will get very difficult for Tesla. We will continue to monitor the German OEM’s and work on a more in-depth review of Daimler in particular.
China – getting worse not better
A somewhat surprising development communicated by several companies (e.g. Assa Abloy, Kone and Siemens) was the accelerating weakness in the Chinese economy. Until recently, the consensus view amongst the industrial sector was that China was still weak but not getting worse.
The organic growth in China for Assa Abloy – the No. 1 global lock and security company – serves as a good proxy for the overall weakness. During 2015, Assa Abloy’s Chinese sales declined by over 5%. Conditions have continued to deteriorate further in recent quarters, with double digit sales declines reported by the company in 2016, and outlook commentary from management suggests we will likely see continued weakness looking into 2017. We got similar indications and commentary from both Kone and Siemens.
Key Takeway: closely monitor the accelerating weakness in China and potential effect this may have on stocks that we hold in the portfolio.
Over the last 20 years we have heard some pretty grim outlook statements from airline CEO’s, but the presentation we attended from the new Air France KLM CEO, Jean-Marc Janaillac, has topped them all. While we have very little interest in airlines themselves, what they have to say can give us helpful insights into numerous related industries.
In a nutshell, Mr Janaillac made it clear that France as a tourist destination has become extremely challenged in the wake of the recent terrorist attacks.
Key Takeaway: While there are clear ramifications for the airlines themselves, we would make the point that there will be residual effects on the economy itself and some of the luxury companies who are somewhat dependant on tourism.
After an extended period of poor fundamentals in the global luxury sector, we were keen to get some updates from the major luxury names on the current environment. Thankfully we have been very well positioned of late, by having no exposure to the major laggards like Hugo Boss, Luxottica, Swatch and Richemont which have all declined by more than 20% over the last 12 months. Using LVMH as a luxury proxy – what we essentially heard from the sector was that the environment remains really tough, even to the point where they are talking about ‘portfolio rationalisation’ and ‘cost cutting’. These types of measures are typically not instigated by luxury companies unless they see a sustained period of weakness.
Key Takeaway: there is still meaningful earnings risk in the luxury space.
Opportunistic value in pharma companies due to US election uncertainty
After meeting with a large number of Healthcare companies during our trip, it is clear that there is still a great deal of uncertainty surrounding the outlook for drug pricing and the potential impact of biosimilars in the US. However, even if Hillary Clinton wins the election, major regulatory reform will be difficult to achieve, especially if the Republicans retain control of the House of Reps.
Key Takeaways: While near term volatility may persist, we remain confident in the medium to long term outlook for the healthcare names in our portfolio and have been using share price weakness to add to positions in a number of high quality companies such as Johnson and Johnson, and Roche, which offer attractive long term upside potential.
The Great Danes
It is quite amazing to see a large concentration of quality companies in a relatively small country like Denmark with a population of 5.6 million people. The meetings undertaken reaffirmed our view that Danish companies tend to have sensible ownership structures, are committed to invest in their businesses, are very profitable, and often have very strong / sustainable franchises.
When it comes to measuring the quality of companies we believe that looking at Return on Capital and various growth metrics can provide a solid unbiased perspective. When we look at our Danish basket of stocks of interest – Chr. Hansen, Coloplast, Novo Nordisk, Novozymes, Pandora, Simcorp and William Demant – the numbers paint a glowing picture. More specifically, the average Return on Capital is 34%, Long Term EPS Growth forecast of 15%p.a. and one year forward sales growth and EPS growth forecasts of 8% and 11%, respectively. Note that these companies are not minnows – average market capitalisation of $33bn.
Key Takeaway: Our meetings reaffirmed our positive view on existing Danish portfolio holdings and identified some other excellent Danish companies that could warrant a position in our portfolio subject to valuation considerations.
Companies generating interest
We met with a large number of companies on this trip but the key stocks that we are now focusing our attention on are listed below. Further, we have also provided a brief overview of some of the more interesting companies:
Ambu is a very interesting Danish health equipment company with a very unique value proposition.
The main driver of the company in the next few years will be a product called the aScope – a disposable fibre optic scope used by surgeons to assess a patient’s airway during a general anaesthetic procedure. Over time, there is a great opportunity for the aScope to take meaningful market share from the existing re-usable scope providers. Re-usable scopes are expensive, unreliable and often result in patient infections, while the disposable aScope helps to avoid contamination, only costs $300 each and operates in a similar fashion to the existing scopes, making the transition easier for surgeons.
Ambu’s CEO, Lars Marcher, is an impressive and passionate executive who is the driving force behind the company’s transformation.
We forecast considerable improvement in profitability. While the current ROE of 24% is impressive, we would expect that number will expand meaningfully in years to come. Based on our initial estimates we anticipate material upside to consensus earnings forecasts for 2017 and beyond, particularly given the stock is not extensively covered by sell-side analysts.
Rightmove is a company we have held in our portfolio in the past. The company dominates the online property listing industry in the UK. As an asset light business, Rightmove generates extremely high Returns on Capital.
The company has been able to deliver excellent revenue and earnings growth over an extended period. In spite of new competition in recent years, they have been able to successfully defend market share without sacrificing margins.
Huhtamaki is a profitably growing Finnish SMID cap name with excellent ESG characteristics. Specifically, they are a global specialist in disposable packaging for food and drink with leading positions in takeaway coffee cups, candy wrappers and fast food packaging.
The company’s true edge lies in its track record and expertise in recyclable and renewable materials, which currently represent 1/3 of volume but should represent around 50% by 2020.
In our view Huhtamaki has excellent long term-growth potential and management have a clear strategy to expand their presence through emerging markets and further penetrate the U.S. market. Our projections suggest that the company can grow revenues by at least one third and nearly double EPS in the next 4-5 years, while simultaneously improving returns.
Moncler is an Italian luxury brand well known for its iconic down jackets. Under the leadership of highly respected CEO, Remo Ruffini, the company has done an excellent job of growing sales outside of Italy in a measured way that ensures strong brand equity is retained. The company is also now pushing ahead with diversifying their exposure into other product categories such as knitwear, footwear, luggage and soft accessories.
Moncler is highly profitable – its 33% EBITDA margins are higher than most luxury peers (with the exception of Hermes) and the company is soon expected to enter net cash territory after deleveraging since their IPO in 2013.
After meeting with the company at their headquarters in Milan, we got a greater appreciation of the quality of the company and believe they are well placed to avoid some of the missteps made by other luxury brands in expanding too quickly. We would expect the company to deliver 10% top line growth and mid-teens EPS growth from now until 2020, which compares very favourably with the Consumer Discretionary sector as a whole. We continue to build our investment thesis on the name and are closely monitoring Moncler’s valuation for an attractive entry point.
Rational is a German specialty manufacturer of food preparation appliances for caterers, restaurants, hotels and canteen kitchens. Their appliances essentially make food preparation considerably more efficient for customers and have quite short payback periods.
They have generated Return on Capital in excess of 30% for 10 consecutive years. They have also managed to grow revenue and profit in a very consistent fashion for over a decade. The recent introduction of a compact version of the SelfCookingCentre opens up a new range of potential customers for the company.
Post Brexit, what companies are saying
UK based companies that we met with seemed somewhat unperturbed by the economic fallout of the Brexit vote. Those companies with exposure to the UK consumer indicated very little change in overall spending behaviour. However, we expect that volatility will rise now that Theresa May has announced she will trigger Article 50 by March 2017, enabling the complex negotiations to leave the EU to begin. As long term investors, we would expect that the uncertainty that comes with the negotiations may present us with some interesting valuation opportunities.
Growth Scarcity: Small and Mid Cap opportunities
Of the 308 names in Europe that pass our initial profitability filter, 86% classify as being small and mid cap according our definition (i.e. bottom 28% of the index). As a group, these companies are forecast to grow Sales at 6.6% and EPS at 9.2% over the coming 12 months – far outstripping their sluggish larger peers. Of the 68 investible companies that we met with – 40 of them were small and mid cap. Companies in this category that piqued our interest during the trip included; Ambu, Brembo, DIA, Huhtamaki, Ipsen, Moncler, Nemetschek, Rational, Rightmove and Simcorp.
Investing for Growth
As long-term fundamental investors – one of the first questions we ask ourselves about a company is – how will they grow over the long term? While economic factors usually have some bearing on growth, a company’s pipeline of products / services is the material driver that is in the control of management.
During the research trip we were encouraged by what we heard from a range of different companies in terms of the level of investment spending on their pipelines and innovation that will help to position them for sustainable success over the long term. Many of these companies, particularly in Denmark and Germany, had one thing in common – a committed majority shareholder who supports management in making strategic decisions that will benefit the company from a long term perspective.
While in some situations majority ownership structures can lead to poor governance standards, we found that for most of the companies we met with, this structure was actually a big positive given it allows management to take a true long term view and not get too distracted by the need to deliver short term earnings performance.
What does all this mean for our client portfolios?
The purpose of the trip was to build on our pipeline of potential investment opportunities. Our meetings have uncovered some very high quality companies that will be considered for inclusion in the portfolio and therefore we believe that the trip was a success.
Having come from an underweight position in European equities in mid-2015, we have been steadily building our positions in European equities as they have lagged U.S. equities by 13.6% over the last year. As valuations become more attractive, we have become more constructive on European names as we have simultaneously taken profits in the U.S. Our portfolio is currently overweight in European equities to the tune of 6.7% which is probably a pretty fair reflection of where we are finding value in our global quality universe. While the sluggish economic environment is apparent for everyone to see, as bottom-up stock pickers, we remain confident in our ability to find great long term money making ideas for our client portfolios.
Important Information: This report has been prepared by Bell Asset Management Limited (BAM) for information purposes only and does not take into consideration the investment objectives, financial circumstances or needs of any particular recipient – it contains general information only and should not be considered as investment advice and should not be relied on as an investment recommendation. Before acting on any information, you should consider your needs and objectives, consult with a licensed financial adviser and obtain a copy of the offer document, which is available by calling BAM on 1300 305 476. No representation or warranty, express or implied, is made as to the accuracy, completeness or reasonableness of any assumption contained in this report and none of BAM and its directors, employees or agents accepts any liability for any loss arising, including from negligence, from the use of this document. Past performance is not necessarily indicative of expected future performance. The securities identified above are not necessarily held in all client portfolios and should not be considered as recommended for purchase or sale.